Financial & Operations Compliance

One of the main roles of IIROC’s Financial and Operations Compliance department (FinOps) is to assess whether firms have enough capital for the type and scope of their business activities. FinOps monitors firms for compliance with IIROC financial rules to reduce the possibility of financial failure due to excessive leverage or risky business practices.

FinOps Information

FinOps monitors the financial status of IIROC-regulated firms and enforces compliance with IIROC rules. The main elements of the department’s work are:

Review of financial regulatory filings – FinOps staff review monthly financial reports and year-end audited joint regulatory financial questionnaires and reports to identify changes in trends, financial status and profitability. When necessary, IIROC can take preventive measures to preserve the capital position of a firm and protect client money and securities. Any investment dealer that does not meet minimum capital requirements is referred to as capital-deficient. The firm must immediately rectify its capital position or face possible suspension or termination of membership.

Annual and biennial "surprise" field examinations – FinOps staff conduct "surprise" examinations of each investment dealer’s books and records to ensure the reliability of their unaudited regulatory filings.

Review of audit working papers – Each IIROC-regulated firm is subject to a year-end audit by an approved panel auditor to validate the information filed by the firm with IIROC. To ensure the quality of the audit, FinOps staff review the panel auditor’s working paper files within three months of the filing date of the firm’s joint regulatory financial questionnaire and report.

IIROC rules require firms to protect client assets by keeping them separate, or segregated, from their own assets. This minimizes the risk of client assets being lost if the firm suffers failure or insolvency.

If problems arise and a regulated firm becomes capital deficient, IIROC immediately intervenes. IIROC allows the firm 24 to 48 hours to remedy the situation generally by injecting new capital into the firm or facing immediate suspension if it is determined there is a risk of an imminent financial loss to the investing public. Membership suspensions are promptly communicated to the public, and all capital deficiencies are reported to Enforcement for possible disciplinary action.

Early Warning System

The Early Warning (EW) system measures the capital, profitability and liquidity position of IIROC-regulated firms to monitor their financial health.

Data from a firm’s monthly and yearly reports are used to calculate its Risk Adjusted Capital (RAC). The EW system measures a dealer’s RAC against certain arithmetical benchmark tests designed to detect the risk of insolvency. For example, staff determine the ratio of capital erosion, measured in months, by looking at the trend in reported operating losses relative to the remaining available capital of a firm.

If an IIROC-regulated firm fails any of the EW tests, or if IIROC determines its condition is unsatisfactory, the firm may be designated Early Warning Level 1 or Level 2, depending on the degree of risk. Rule 30 imposes standard restrictions on Dealer Members designated at each level.

To place a firm in Early Warning does not indicate that the public is currently at risk. The restrictions allow IIROC to require the firm to pause and re-assess its business model, implement changes such as cost rationalization measures or recapitalize. IIROC will closely monitor the firm's ongoing financial results and determine whether the measures have a positive effect or there is need for additional regulatory intervention to prevent the firm from incurring a capital deficiency.

In the event that a firm actually becomes capital deficient, meaning its RAC drops below an acceptable level, it is given no more than 24-48 hours to remedy its RAC or face immediate suspension if there is any likelihood of financial loss to the public.

Membership suspension notices are public information. Material breaches in capital requirements are referred to Enforcement for possible disciplinary action. All clients of IIROC-regulated firms are covered by the Canadian Investor Protection Fund (CIPF), which protects clients in the event that a Dealer Member firm becomes insolvent.

Risk Assessment Model (FinOps)

The Financial & Operations Compliance Risk Assessment Model is a risk management tool to help identify, define, assess and weigh risks in respect to IIROC Dealer Member firms and determine priority focus in IIROC’s examination cycle of Dealer Member firms.

Essentially, the model gives an indication of the comparable risk assessed for each IIROC-regulated firm relative to its peersand all other firms under IIROC’s jurisdiction.

The objective of the FinOps Risk Assessment Model is to identify regulated firms having a higher than average probability of incurring a capital deficiency. With this information, IIROC ensures that regulatory focus is placed on higher-risk firms.

The model identifies two risk types, six risk categories and twenty specific risks. Each specific risk is assessed and weighted to determine an individual firm business risk score. See Components.

The model then calculates the risk control score by identifying two risk control categories and eight specific risk controls. Each specific risk control is assessed and weighted. Risk control is the method the firm uses to mitigate or reduce its business risk. The higher the risk control score the higher the quality of overall risk control.

The resulting risk control score is discounted and 40% of the score is subtracted from the business risk score to achieve a residual risk score for each firm. The discount factor is applied consistently to all Dealer Member firm risk control scores to better differentiate residual risk scores.

Purpose:This FAQ document has been prepared to assist Dealer Members in understanding the approval process over regulatory capital1, either by the Dealer Member issuing shares 2 or debt.

For clarity, we have supplemented the FAQ with decision trees – Exhibits 1 to 3. These decision trees illustrate the approval process for change requests from Dealer Members relating to the regulatory capital in the business. Exhibit 4 is a standard risk disclosure acknowledgement form that is required when a non-industry investor is involved.

Where are the IIROC rule references for eligible sources of regulatory capital?

IIROC Dealer Member Rules 5 (Ownership of Dealer Member securities) and 6 (Dealer Member holding companies, related companies and diversification) provide the basis for the sources of regulatory capital for a Dealer Member. For a comprehensive reading of these rules, you will need to refer to IIROC Dealer Member Rules 1, 7 and 17.

Who are the source providers of eligible regulatory capital?

Any person [whether an individual, partnership (general partnership or limited partnership), corporation (publicly owned or privately held), trustee or unincorporated organization] may invest in or lend to a Dealer Member subject to compliance with the applicable Dealer Member rules.

What are the main sources of eligible regulatory capital?

In addition to internally generated profit and retained earnings and Form 1 capital allowances relating to the accounting of non-refundable leasehold inducements by landlord of office premises, the two sources of regulatory capital in an IIROC Dealer Member are:

a) from persons investing in the Dealer Member by way of equity – whether through common shares or preferred shares

b) from persons lending funds to the Dealer Member by way of subordinated loan

Regulatory capital can take the form of equity (common and classes of preferred shares) and the form of debt supported by an industry prescribed subordinated loan agreement.

Equity in the firm

Debt to the firm

Common shares

Classes of Preferred shares

Special warrants, options and any other security with a convertible feature

Subordinated loan

Are all classes of preferred shares considered eligible regulatory capital?

No. Preferred shares that have a retraction feature - where the shareholder retains the right at their option to redeem the preferred shares – are not considered as eligible regulatory capital for purposes of Form 1, unless the terms of the retraction feature is subject to IIROC approval. Classes of preferred shares that are redeemable only at the option of the Dealer Member are permitted as eligible regulatory capital. To address IFRS accounting departures 3, Form 1 permits balance sheet classification for such preferred shares as issued capital (as opposed to liabilities).

How is the percentage ownership of a Dealer Member calculated for purposes of seeking IIROC approval for changes in capital structure?

For purposes of regulatory review and approval, the shareholder interest of a Dealer Member is generally calculated on a fully diluted basis. That is, in determining the economic interest of shareholders, consideration must be given to all classes of shares, options and warrants outstanding and conversion features of subordinated debt outstanding.

Changes in share capital that result in shareholdings (on a fully diluted basis) that meet or exceed thresholds of 10%, 20% and 50% will determine the extent of IIROC due diligence review of the transaction and the approvals required. For example, this calculation will be used with respect to the holding company (IIROC Dealer Member Rules 6.1 and 6.2), related company (IIROC Dealer Member Rules 6.3 to 6.5) and guarantee agreement requirements (IIROC Dealer Member Rule 6.6).

For the purposes of determining a significant equity interest (10% or greater interest) under IIROC Dealer Member Rule 5.4, consideration must also be given to whether the threshold has been met based on the projected issued and outstanding shareholdings (on an undiluted basis) following the proposed transaction.

Also, refer to IIROC Dealer Member Rules 5 and 6 for special provisions governing ownership by (a) industry investors in Dealer Members other than the Dealer Member for which the investor is employed/approved and (b) Dealer Members in other Dealer Members.

Is IIROC approval required for any change (either increase or decrease) to the Dealer Member’s regulatory capital?

Yes. For both sources (equity and debt), the Dealer Member must obtain regulatory approval before the funds can be treated as eligible regulatory capital.

Where are requests for changes in regulatory capital amount or structure sent? And how much lead time is needed in order to get approval?

As a general rule, for any changes either to the regulatory capital amount or the capital structure of a Dealer Member, a notification letter must be sent to the Membership Coordinator in IIROC’s General Counsel’s Office (GCO) at least 20 calendar days 4 before the planned effective transaction date.

Specifically for changes to a subordinated loan, a request for approval letter must be sent to the Vice President of the Financial & Operations Compliance (FinOps) department.

Please allow for additional time if the proposed transaction will require approval of the District Council.

Three IIROC departments – General Counsel’s Office (GCO), Financial & Operations Compliance (FinOps) and Registration may be involved in the review and approval process.

Depending on the form of regulatory capital and the percentage ownership interest, the following departments will lead the review and approval process and will determine the extent of IIROC staff due diligence review required:

Form of regulatory capital

Threshold

Primary IIROC department

Equity

Less than 10% ownership

GCO

Equal or greater than 10% ownership

Registration

Debt

FinOps

For share capital changes (increases and decreases), what supporting documents are required to be provided by a Dealer Member?

A notification letter from the CFO (addressed to GCO) dated at least 20 calendar days before the planned effective transaction date describing the change in regulatory capital structure

A list of all shareholders (of all classes) – before and after the transaction – showing the shareholder names with the number and percentage of shares owned on an issued and outstanding (undiluted) basis and a fully diluted basis and highlighting increases in shareholder interest of and over 10%

Investor Notification Forms (INF) and Investor Application Forms (IAF) for new investors and investors proposing to own 10% or more of the Dealer Member, respectively

The most recent Risk Adjusted Capital (RAC) of the firm and the pro-forma impact on both RAC and Early Warning calculations – before and after the transaction

IIROC early warning rules specifically do not permit a firm to alter its capital structure that would result in triggering the early warning criteria (including payout of dividends).

What concerns does IIROC have in respect to subordinated loan investors that are not otherwise officers or employees of the Dealer Member?

As issuing of debt is considered under provincial securities laws an exempt distribution, subordinated loan investors must meet the definition of accredited investor or otherwise qualify to participate in the transaction. In addition, given the illiquidity of this type of investment and the potential lack of transparency and conflicts of interest, as a condition for IIROC approval, the Dealer Member must obtain written acknowledgement from the investor regarding: the receipt of full and sufficient financial and regulatory information about the Dealer Member, the investor’s understanding of the specific risks associated with the investment, including conditions of repayment being subject to regulatory approval and the receipt (or waiver) of independent financial advice.

How can a commercial revolving loan facility between a Dealer Member and an approved industry investor be structured as a subordinated loan?

It is common - after the elimination of standby subordinated loans - for Dealer Members to pre-arrange a revolving loan facility with a bank or an affiliate and to put in place a subordinated loan agreement that can be amended from time-to-time to reflect drawdowns and repayments.

To set up a revolving commercial loan arrangement so that it becomes subordinated debt, a Dealer Member will start by submitting to IIROC a standard subordinated loan agreement for at least the nominal amount of $1. Once the subordinated loan is approved and executed by IIROC, any drawdown (and any future repayment subject to IIROC approval) in respect to the commercial loan arrangement is evidenced as an amendment to Schedule A.

Footnotes:

1Regulatory financial statement capital as reported on Statement B line 4 of Form 1

2 In the case of Dealer Members that are structured as partnerships, the equivalent source is partnership capital.

3 Refer to Note 2 of the General notes and definitions to Form 1 (the regulatory financial report).

Rule 100 sets out the minimum capital and margin requirements for the vast majority of securities that are held by a Dealer Member or its customers. Whether or not a security is eligible for margin and if so, the minimum rate to be used is set out in this Rule. The major categories of securities covered by the Rule (along with the Rule reference) are:

What if there are no capital and margin requirements set out in Rule 100 for the particular security that I am looking for?

While Rule 100 sets out the minimum capital and margin requirements for the vast majority of securities, there are instances in the rules where either individual issues or types of securities have no established requirements. When these situations occur, IIROC staff issues guidance notices to establish the appropriate requirements. In the absence of specific requirements or guidance, a Dealer Member may request a ruling from the Member Regulation Policy Department on the proper capital and margin treatment for a specific transaction or position. When a ruling is requested, it must be in writing and full details of the transaction/position must be provided. See IIROC Rules Notices, IDA Member Regulation Notices and IDA Compliance Interpretation Bulletins for more information.

Is there any other information available on the application of Rule 100?

Each year IIROC holds a Member & Panel Auditor Seminar to provide specific training to Dealer Member staff and panel auditors on a number of issues. Generally, at least one session is provided on significant changes to Rule 100 made during the past year. Furthermore, there may be additional sessions dealing with specific capital and margin related topics of interest. In the past few years these sessions have covered the following topics: capital requirements for Dealer Member inventory offsets, securities concentration charge, capital requirements for underwriting positions and provider of capital concentration charge.

Also, the following margin rate lists are updated regularly and are available on the Supporting Schedules page:

List of foreign exchange (FX) spot risk margin rates for Canadian and U.S. base currency accounts

Foreign currency group.

Where can I get a copy of the lists that are used for determining counterparty credit risk classification?

The following lists relating to counterparty credit risk classification are available on the Supporting Schedules page:

Acceptable institutions / acceptable counterparties database

Countries that qualify under the definition of Basle Accord Countries [used to determine whether a foreign counterparty may qualify as an acceptable institution or an acceptable counterparty]

Exchanges / associations whose members qualify as regulated entities

List of approved inter-dealer bond brokers [used to determine those inter-dealer bond brokers that may be margined in the same manner as acceptable counterparties]

List of acceptable clearing corporations and acceptable securities locations (depositories and clearing agencies) [depositories and clearing corporations that qualify as acceptable clearing corporations receive better credit treatment as per the Notes and Instructions to Schedule 5 of IIROC Form 1]

Can I treat an institution as an acceptable institution or an acceptable counterparty even though they are not listed in the acceptable institutions / acceptable counterparties database?

Yes, as long as you make sure that such an institution qualifies as an acceptable institution or an acceptable counterparty based on the most recent audited financial statements available for the institution. The requirements for qualifying as an acceptable institution or an acceptable counterparty are set out in the General Notes and Definitions of IIROC Form 1, the Joint Regulatory Financial Questionnaire and Report.

Where can I get a copy of the lists that are used for determining whether a custodial location is acceptable for regulatory purposes?

List of acceptable clearing corporations and acceptable securities locations (depositories and clearing agencies) [depositories and clearing corporations that qualify on this list qualify as acceptable securities locations without the IIROC Dealer Member having to execute a separate custodial agreement]

List of financial institutions / entities / mutual funds with signed Custodial Agreement [entities on this list have signed a Bare Trustee Custodial Agreement with IIROC and they qualify as acceptable securities locations for the specific investment products listed without the IIROC Dealer Member having to execute a separate custodial agreement]

List of entities considered suitable to hold LBMA gold and silver good delivery bars [entities on this list qualify as acceptable securities locations for holding gold and silver bars that meet the London Bullion Market Associations (LBMA) gold and silver good delivery bars standards; the IIROC Dealer must still execute a separate precious metals custodial agreement].

Where are the standard industry agreements located on your website?

Copies of standard industry agreements are maintained in a separate section within the Supporting Schedules page.

Can an employee of a Dealer Member guarantee the trading account of another employee of the same firm or a client's account?

An employee can guarantee another employee's trading account as long as the guarantor has sufficient excess margin in his/her account. An employee may not guarantee a client account. However, IIROC Rule 100.15 provides for certain exemptions for partners, directors or officers of a Dealer Member to guarantee a clients account, provided certain conditions are met.

Can a family member of an investment advisor guarantee the investment advisor's account?

IIROC Rule 100.15(d) allows immediate family members of the investment advisor to guarantee the investment advisor's account.

Can a Dealer Member provide a financial guarantee to a third party?

According to the Notes and Instructions to Statement B of IIROC Form 1, a Dealer Member may give, directly or indirectly, financial assistance to an individual and/or corporation by means of a loan, guarantee, the provision of security or of a covenant or otherwise, if the amount of the loan, guarantee, provision of security or of the covenant or any other assistance is limited to a fixed or determinable amount and the amount is provided for in full in computing the Dealer Members Risk Adjusted Capital.

Do insurance companies have to be registered in Canada in order to be able to issue an FIB policy to a Dealer Member?

Insurance required to be in force by a Dealer Member pursuant to IIROC Rule 400 may be underwritten directly by either (i) an insurer registered or licensed under the laws of Canada or any province of Canada or (ii) any foreign insurer approved by the Corporation. No foreign insurer shall be approved by the Corporation unless the insurer has the minimum net worth required of $75 million on the last audited balance sheet, provided acceptable financial information with respect to such Corporation is available for inspection, and the Corporation is satisfied that the insurer is subject to supervision by regulatory authorities in the jurisdiction of incorporation of the insurer which is substantially similar to the supervision of insurance companies in Canada.

Do Dealer Members have to limit their insurance coverage to the maximum $25 million?

While Dealer Members have to ensure that they provide the minimum required insurance coverage, it would be prudent for the Dealer Member to have adequate coverage, based on their business needs, regardless of the maximum set in IIROC Rules.

Do Dealer Members have to report their client net equity on Schedule 10 even if they are providing the maximum required coverage of $25 million?

Yes, IIROC requires the client net equity to be reported on Schedule 10.

Can a Dealer Member use an insurance policy other than Form 14, as long as the policy contains the required clauses?

Yes, Dealer Members may use a policy other than Form 14, as long as the member can provide IIROC with legal opinions that the policy meets the minimums stipulated in Form 14.

Does the maximum required coverage of $25 million apply to all clauses of the FIB Policy?

The maximum coverage applies to all FIB policy clauses except for the in-transit clause C, where the required coverage must be in place on a dollar for dollar basis (IIROC Rule 400.2(c)).

Can temporary insurance coverage be arranged for the in-transit requirements should such requirement be infrequent?

Yes.

Can a Dealer Member use the courier’s insurance in lieu of the in-transit coverage?

No.

Should certified cheques be included in the calculation of the in-transit requirement if they are being transported to and from the Dealer Member’s offices?

No.

What is the logic of requiring a double aggregate limit for the FIB policy where such limit is stipulated?

The requirement was made so that the coverage is extended to two simultaneous losses incurred by a Dealer Member at the same time.

How should a double aggregate limit of $10 million coverage be reported on Schedule 10?

10 million

Can a Dealer Member who has a required double aggregate coverage of $10 million use a single aggregate of $20 million?

Yes. The objective of the double aggregate limit requirement in IIROC Rule 400 is to ensure that two simultaneous losses are covered.

Do carriers have to include the client net equity of their introducers (type 1, 2, 3 &4) in their own calculation of their insurance coverage?

Yes. Since the carrier has access to or control of the introducers’ client assets, then all such assets must be included in the carrier’s insurance calculation. The insurance requirement is based on the concept of stealable assets.

Do introducing Dealer Members have to have their own insurance coverage or can they rely on the carrier’s coverage?

Introducers (of all categories) must have their own insurance coverage based on their own client net equity regardless of the carrier’s coverage. In spite of the duplication of the client net equity coverage, insurance requirement is a minimum membership requirement that Dealer Members have to comply with.

If a carrier picks up securities from the introducer’s premises, whose insurance coverage would be used to cover the in-transit requirement?

The carrier’s policy would cover the in-transit requirement.

If the introducer ships securities to the carrier, whose in-transit coverage would be applicable?

It would be the introducer’s coverage that would be required to cover the shipment.

Is there a limit on how high the insurance deductible can be set at?

While the answer to the question is “No”, it should be understood that the concept of self-insurance is not acceptable. In other words, it is not acceptable for a member to provide capital in lieu of the insurance requirement.

What should a Dealer Member report as the actual insurance coverage on Schedule 10 if it is different for the various clauses (A through E) of the policy?

The minimum common denominator must be used for reporting the actual insurance coverage on Schedule 10.

For IIROC Dealer Members who are cross-guaranteed, do they require separate insurance coverages?

All IIROC Dealer Members must comply with the minimum standards of membership, which includes insurance coverage. If two Dealer Members are cross-guaranteed, they could either have their own separate policies or they could both be named in the same FIB insurance policy. If the latter, IIROC Rule 400.7(a) would not be an issue because of the cross-guarantee.

Can individual or aggregate limits under the policy be affected by claims made by or on behalf of any of the Dealer Member’s subsidiaries?

According to IIROC Rule 400.7 (b)(ii), such individual or aggregate limits may only be affected by Member’s subsidiaries whose financial results are consolidated with those of the Dealer Member. Consolidation in this context applies to related companies, as defined in IIROC Rule 1.1 and not in terms of accounting consolidation of subsidiaries.

How would you deal with FIB policies that have other entities included in the policy?

Other entities may be included in the Dealer Member’s policy by way of a global policy that must contain the required provisions stipulated in IIROC Rule 400.7. The important thing to note is that the Dealer Member’s coverage is kept intact.

If a Dealer Member has a full reinstatement provision, should it be problematic to have other entities being included in the policy?

No, as long as the Dealer Member is the first named insured and the Dealer Member’s coverage is kept intact.

How soon do insurance coverage violations have to be corrected?

Violations that do not exceed 10% of the insurance requirement must be corrected within two months of their determination. For violations of 10% or more, action must be taken by the Dealer Member to correct the deficiency within 10 days of their determination and the Dealer Member must immediately notify the Corporation.

Does the insurance coverage requirement vary depending on the negotiability of securities?

In accordance with IIROC Rule 400.5(f), for the purposes of calculating insurance requirements, no distinction is to be made between securities in non-negotiable form and those in negotiable form.

What is a primary insurance coverage and how is it different from secondary coverage?

Insurance coverage may be broken into more than one policy. One or more insurers may be involved and one of the coverages might be a global type while the other may be a direct coverage. A primary coverage would normally be for a certain amount, with a deductible. The secondary coverage would represent another layer of coverage with the deductible representing the same amount of primary coverage. The secondary coverage might be part of a global-policy coverage.

Can mail insurance be part of the FIB Coverage or does it have to be the subject of a separate coverage?

The registered mail coverage can be put into place via a separate policy or through a rider to the FIB Form 14. The amount of the required coverage has to be enough to cover actual usage with no stated minimums.

Is there a minimum mail insurance requirement?

No, the required coverage is based on actual usage.

Can mail insurance be part of a global coverage?

Yes, mail insurance can be part of a global coverage. If so, however, the mail coverage should be subject to the same global policy provisions noted in IIROC Rule 400.7.

Is mail insurance subject to the requirement to provide the IIROC with a 30-day cancellation notice?

Yes, mail coverage, per IIROC Rule 400.3, should be treated no differently than normal FIB coverage.

Can a Dealer Member be exempted from the registered mail insurance requirement?

Yes, IIROC Rule 400.1 has been amended whereby the Corporation may exempt a Dealer Member from the requirement if the dealer member delivers a written undertaking to the Corporation that it will not use the mail for out-going shipment of money or securities, negotiable or non-negotiable, by first-class mail, registered mail, express or air mail.

Are agents acting in a principal/agent relationship (IIROC Rule 39) covered for insurance purposes under the standard Form 14 FIB policy?

IIROC Rule 39.4(f) requires that the financial Institution Bond and insurance policies required to be maintained by the Dealer Member pursuant to IIROC Rule 17 and IIROC Rule 400 cover and relate to the conduct of the agent. To comply with IIROC Rule 39.4(f), a Dealer Member must have an agent rider added to its FIB in order to ensure that all its agents and the employees of those agents are covered by the FIB (Form 14) to the same extent as the firm’s own individual employees.

Are Dealer Members required to have excess CIPF coverage?

Excess CIPF coverage is intended to provide added protection to clients of a Dealer Member in the event of an insolvency that is over and above the CIPF coverage limits. While this is a competitive advantage, it is not a minimum membership requirement.

When the auditor confirms the financial institution bond at the time of the year-end audit, can the confirmation be with the insurance broker or should it be confirmed with the insurance underwriter?

The audit confirmation may be made with either the insurance broker or the insurance underwriter.

Does the requirement of a double aggregate limit (where an aggregate is stipulated) apply to registered mail insurance coverage?

An Introducing Broker/Carrying Broker Arrangement is an agreement entered into between two Self Regulatory Organization (“SRO”) members that allow one firm (the “Introducing Broker”) to use the back office of another firm (the “Carrying Broker”) to perform certain trading related functions on its behalf.

Now that the MFDA has been recognized as a SRO, does this mean that MFDA Member firms can now enter into introducing broker/carrying broker arrangements with IIROC Dealer Members?

In addition to requiring that both the introducing broker and the carrying broker be members of a SRO, IIROC Rules 35.1(b) and 35.1(c) require both firms be members of a SRO that is a participating institution in the Canadian Investor Protection Fund. Currently, the only SRO that is a participating institution in the Canadian Investor Protection Fund is the Investment Industry Regulatory Organization of Canada. As a result, MFDA Member firms are not permitted at this time to enter into introducing broker/carrying broker arrangements with IIROC dealer members.

What trading related functions in combination are considered to be an Introducing Broker/Carrying Broker Arrangement?

Certain combinations of functions provided by one Dealer Member to another constitute an Introducing Broker/Carrying Broker Arrangement, whereas other combinations of functions do not. The following are six main trading related functions that are performed:

Function #1

Function #2

Function #3

Function #4

Function #5

Function #6

Trade execution

Trade settlement

Custody of cash

Custody of securities

Bookkeeping

Financing of customer positions

Functions or combinations of functions that do not constitute an Introducing Broker/Carrying Broker Arrangement include:

Functions #1 and #2

This combination of functions is a “jitney” or “omnibus” arrangement and is not subject to the requirements of the Introducing Broker/Carrying Broker Arrangement rules, as set out in IIROC Rule 35.

Functions #2, #3 and #4

This combination of functions is a custodial arrangement and is not subject to the requirements of the Introducing Broker/Carrying Broker Arrangement rules, as set out in IIROC Rule 35. Of course this arrangement is subject to other requirements set out in the IIROC Rule Book relating to custody of customer cash and securities.

Functions #1, #2, and #5

This combination of functions is not subject to the requirements of IIROC Rule 35. The introducing broker/carrying broker requirements do not apply where cash and security custody is kept separate and assets are not commingled in any way with the service provider’s assets. This requires distinct segregation of securities by means of individual account FINS #s at the Canadian Depository for Securities Ltd. or other depository for securities of the servicee.

Functions #5

The preparation of books and records is not subject to the requirements of IIROC Rule 35. This function is typically performed by a service bureau with the Dealer Member retaining the responsibility to comply with the IIROC Rule Book requirements for bookkeeping.

Combinations of functions that do constitute an Introducing Broker/Carrying Broker Arrangement include:

Functions #1 through #6

This combination of functions is subject to the introducing and carrying broker rules and is classified as either a Type 1, 2 or 3 Arrangement pursuant to IIROC Rule 35.

Functions #1 through #5

This combination of functions is subject to the introducing and carrying broker rules where financing of customer positions is performed by the introducer and is classified as a Type 4 Arrangement pursuant to IIROC Rule 35.

Functions #2 through #6

This combination of functions is subject to the introducing and carrying broker rules where trade execution is performed by the introducer and is classified as either a Type 2 or 3 Arrangement pursuant to IIROC Rule 35.

Functions #2 through #5

This combination of functions is subject to the introducing and carrying broker rules where trade execution and financing of customer positions is performed by the introducer and is classified as a Type 4 Arrangement pursuant to IIROC Rule 35.

IIROC Rule 35 details four types of permissable Introducing Broker/Carrying Broker Arrangements. Why were four types of arrangements developed and what are the unique characteristics of each type?

When IIROC Rule 35 (formerly IDA By-law No. 35) went through its last major revision in 1997, four types of Introducing Broker/Carrying Broker Arrangements were introduced. The four types of arrangements were developed to give firms increased flexibility to use the excess back office capacity of other firms. The carrying broker is relied on most heavily to perform trading related functions on behalf of the introducing broker under an Introducing Type 1 Arrangement and least heavily under an Introducing Type 4 Arrangement. For details of the unique characteristics of each arrangement please refer to Member Regulation Notice MR096.

Is a Dealer Member allowed to be a full service broker for one segment of their business while introducing another segment of their business to a carrying broker?

Yes, in the case of Dealer Members using either a Type 3 or 4 arrangement, a Dealer Member may introduce a segment of their business to a carrying broker as well as fully service another segment of their business. This ability is limited to Dealer Members using either a Type 3 or 4 arrangement as, under such arrangements, the introducing broker is responsible for reporting customer balances and security positions on its own books. Therefore, the combination of the Dealer Member fully servicing one segment of their business and using a Type 3 or 4 arrangement for another segment will result in all balances and security positions of the customer being reported on the books of the introducing broker.

Requiring all customer balances and security positions to be reported on the books of one Dealer Member is an important regulatory issue. If this was not a requirement, a situation could arise where customer assets might form part of a comfort deposit lodged with a carrying broker. As a result, brokers who enter into Type 1 or Type 2 arrangements for certain business segments are explicitly prohibited from acting as a full service broker for another business segment since under that situation customer balances and security positions would be reported on the books of the introducing broker and the carrying broker.

Can a Dealer Member introduce customers to more than one carrying broker?

A broker can introduce customers to more than one carrying broker where:

The additional introducing broker/carrying broker arrangement relates to the trading of futures contracts and options [IIROC Rule 35.1(e)(ii)]; or

The Dealer Member is a Type 3 or 4 introducing broker and the Dealer Member has established a business case for entering into an additional Type 3 or 4 arrangement [IIROC Rule 35.1(e)(v)].

Can an introducing broker execute a customer trade either through a different carrying broker or a jitney broker?

As stated in FAQ #5 above, there are two situations under which a Dealer Member may enter into more than one introducing broker/carrying broker arrangement. In the case of the first situation, the unique clearing and settlement issues relating to the trading of futures contracts and options necessitate allowing the introducing broker to enter into an additional introducing broker/carrying broker arrangement for this business segment. In the case of the second situation, a business case must be made before a Type 3 or 4 introducing broker would be permitted to deal with more than one carrying broker. As part of any business case developed it is envisaged that additional introduction agreements would only be entered into for unique business segments. As a result, the scenario above where an introducing broker would be permitted to execute a trade through a different carrying broker would not be permitted.

Use of a jitney broker by a Type 1 or 2 introducing broker to execute a customer trade would be prohibited as this would result in the Dealer Member providing “full service” to the customer, which is prohibited under IIROC Rule 35.1(e)(iii). A Type 3 or 4 introducing broker would be permitted to use a jitney broker to execute a trade provided that the introducing broker/carrying broker arrangement entered into with the carrying broker allows for this practice.

Can an introducing broker execute principal trades either through a different carrying broker or a jitney broker?

Type 2, 3 or 4 introducing brokers may execute principal trades through an IIROC Dealer Member other than the carrying broker. Pursuant to IIROC Rule 35.1(e)(iv), Type 1 introducing brokers must introduce all principal trades to their carrying broker due to the lower required minimum capital and insurance coverage applicable to a Type 1 introducing broker.

Can security-lending/financing activities be carried out by the introducing broker under any of the four types of arrangements?

Only under a Type 4 arrangement is the introducing broker permitted to undertake security-lending/financing activities. Under Type 1, 2 and 3 arrangements, lending and borrowing of securities is the responsibility of the carrying broker.

Is a Type 4 introducing broker required to carry out its own security-lending/financing activities?

No. While IIROC Rule 35.5(e) stipulates that the introducing broker is required to carry out its own security lending/financing activities under a Type 4 arrangement, the introducing broker is not prohibited from having the carrying broker perform these activities on its behalf. This would be achieved through the execution of a master security lending agreement with the carrying broker. As the execution of this agreement would modify the nature of the introducing broker/carrying broker arrangement entered into, prior regulatory approval would be required.

Whose name (the introducing broker, the carrying broker or both) should be on contracts, statements and correspondence that relate to introduced customer accounts?

Under a Type 1 or 2 arrangement, the name of both the introducing broker and the carrying broker must appear on all contracts, statements and correspondence relating to any introduced customer accounts. This is because under these arrangements both the introducing broker and the carrying broker have significant performance obligations to the introduced customers. Further, in order to ensure that the customer is aware of the individual roles and obligations of the introducing broker and the carrying broker, a disclosure statement detailing the roles and obligations of both brokers must be provided to the customer at the time they open an account as well as on an annual or ongoing basis thereafter.

Under a Type 3 and 4 arrangement, only the introducing broker's name must appear on all contracts, statements and correspondence relating to any introduced customer accounts. This is because under these arrangements the introducing broker retains the bulk of the performance obligations to the introduced customers. For the most part the carrying broker under these arrangements acts as a securities clearing, settlement and record keeping service bureau. However, as with the Type 1 and 2 arrangements, a disclosure statement detailing the roles and obligations of both Dealer Members must be provided to the customer at the time they open an account as well as on an annual or ongoing basis thereafter.

Is there a standard disclosure statement that should be used?

IIROC Rule 35 specifies the nature of information that must be disclosed to customers of the introducing broker. While there is no standard disclosure text that is required, IIROC has prepared suggested sample disclosure paragraphs which may be used. These sample disclosure paragraphs are available upon request from IIROC.

Is the introducing broker or the carrying broker responsible for customer free credit segregation?

Since it is responsible for the security-lending/financing activities relating to the introduced customer account, the carrying broker is responsible for free credit segregation under Type 1, 2 and 3 arrangements. The introducing broker is responsible for free credit segregation under a Type 4 arrangement as it retains the responsibility for all security-lending/financing activities under this arrangement. If, as described in FAQ #9, the introducing broker chooses to have the carrying broker perform these activities on its behalf, the introducing broker as well as the carrying broker will be responsible for customer free credit segregation.

Since both the introducing broker and the carrying broker must be SRO members, they are both considered regulated entities for account margin purposes. Does this mean that account balances resulting from introduced transactions that arise on the books of the introducing broker or the carrying broker must be margined on a “value for value” basis?

No, account balances resulting from introduced transactions are exempt from being margined on a “value for value” basis. This is because the introducing broker/carrying broker arrangement is a standard industry three party agreement, with the audit jurisdiction SRO being the third party to the agreement. However, where:

a comfort deposit is lodged with the carrying broker by the introducing broker; and

the carrying broker uses a portion of the deposit to cover any margin required on the introduced client accounts;

that portion would need to be reclassified by the introducing broker as a non-allowable asset.

Does the carrying broker have to segregate any comfort deposit it has received from the introducing broker?

Yes, to extent the comfort deposit is not being used by the carrying broker to cover any margin required on the introduced client accounts (as discussed in FAQ #13 above), the comfort deposit must be segregated. If the comfort deposit is in the form of cash, the cash must be kept by the carrying broker in a separate bank account in trust for the introducing broker.

What is the margin requirement to be provided by the Type 1 and 2 introducing broker in the event the carrying broker liens on the comfort deposit?

a)

Client margin deficiency – The carrying broker is permitted to offset any margin required to be maintained against the loan value of any deposit made by the introducing broker to the extent of the risk adjusted capital of the introducing broker. The carrying broker must advise the introducing broker if any margin lien is placed on the comfort deposit. See IIROC Rules 35.2(c) and 35.3(c).

b)

Unsecured accounts – The introducing broker is required to reclassify its comfort deposit as a non-allowable asset for those client accounts that are unsecured. See IIROC Rule 35.2(f) and 35.3(f).

Is the introducing broker or the carrying broker responsible for ensuring that customer securities are properly segregated?

Under IIROC Rule 35, since under all four types of arrangements the carrying broker is responsible for the clearing and settlement of security transactions, the carrying broker is also responsible for the segregation of customer securities. However, should the introducing broker become aware of problems with the segregation of its customers' securities, it has a fiduciary responsibility to ensure that these problems are corrected. Further, it is prudent, particularly for Type 3 and 4 introducing brokers, for the introducing broker to monitor the segregation process to ensure that their customers' securities are properly segregated. This can be accomplished by reviewing a sample of customer monthly statements.

What responsibilities do the auditors of introducing brokers have with respect to the segregation of customer securities?

Since under all four types of arrangements the carrying broker has the responsibility to ensure proper segregation of customer securities, the introducing broker's auditor need not file a security segregation report as part of the annual filing of the Form 1. It is also not necessary for the auditor to obtain a comfort letter relating to segregation from the carrying broker's auditor. The testing of security segregation is to be performed by the carrying broker's auditor for all accounts of, including those accounts introduced to, the carrying broker.

Can the contracting parties modify a standard introducing agreement?

While the clauses of the standard agreements may not be modified, additional provisions may be added to the agreements by way of schedules or appendices (which would also have to be approved by IIROC as part of the agreements), provided that these provisions do not override the standard provisions.

In the case of a Type 3 arrangement, the introducing broker is responsible for the reporting and margining of customer account balances and the carrying broker is responsible for any necessary segregation of customer free credit balances. How does the carrying broker calculate the free credit segregation requirement when it doesn’t report elsewhere in its regulatory filings the free credit balances of introduced customer accounts?

In order to allow the carrying broker to properly calculate its free credit segregation requirement (including any requirement relating to carried customer accounts), Statement D of the Form 1 has been modified to accommodate Type 3 introducing arrangement free credit balances. No similar modification to Statement D was needed to accommodate free credit balances arising from Type 4 introducing arrangements, as the introducing broker is responsible for free credit segregation.

Do carrying brokers have to provide introducing brokers with a security record and position listing securities held for their customers?

Carrying brokers must provide the introducing brokers with a listing of customer securities held and the quantities segregated for Type 3 and 4 introducers. Auditors of Type 3 and 4 introducing brokers must confirm with the carrying broker all securities held.

Do auditors of Type 3 and 4 introducing brokers have to confirm their year-end security positions with their carrying broker?

Yes. IIROC has informed the panel auditors that at the year-end audit time and pursuant to IIROC Rule 300 they are required to confirm all securities held by the carrying broker for Type 3 and 4 introducing brokers. In order to facilitate this process, the carrying brokers are obligated to make available to the introducing brokers at least annually a listing similar to a security record and position report detailing all the securities held for the introducing broker on behalf of each customer.

Do introducing brokers have to enter into a separate RRSP trust agreement with a trustee in order to provide RRSP accounts to their customers?

No, provided that the carrying broker’s agreement with the trustee allows for the use of an agent (the introducing broker) in addition to the carrying broker. All introducers, regardless of type, can use the trust arrangements of the carrying broker.

Can an introducing broker/carrying broker arrangement be entered into with a foreign affiliate?

An arrangement may be entered into between a Dealer Member and a foreign affiliate whereby the Dealer Member carries the account of a foreign affiliate or its customers. To accommodate one of these arrangements one of the standard agreements, may be modified or a separate agreement may be developed to meet both foreign regulatory requirements and the requirements set out in IIROC Rule 35.6.

What kind of Canadian Investor Protection Fund (“CIPF”) coverage would customers of a foreign affiliate have?

The CIPF protects customers of CIPF Members firms. Accounts of foreign affiliate customers that are carried by CIPF Members firms, in accordance with the requirements set out in IIROC Rule 35.6, are considered to be customers of CIPF Members firms and are therefore entitled to CIPF coverage.

What credit policies should an Introducing Broker have in place?

Credit risk management is important for all Dealer Members, including introducing brokers. While carrying brokers impose their credit risk policies on client accounts introduced to them, introducers may implement even more stringent rules. For further details, see IIROC Notice 09-0171 dated June 11, 2009 (Best Practices for Credit Risk Management).

What other reference sources are there on the IIROC web-site relating to Introducing Broker/Carrying Broker Arrangements?

IDA Bulletin #2883, issued on August 31, 2001. This notice announced the implementation of the most recent changes to By-law No. 35.

One of the ways for book entry investment products (including investment funds, segregated funds, guaranteed investment certificates and other evidence of deposits) distributed by an issuer or its agent to be considered held at an acceptable securities location, is for the issuer or its agent to sign a prescribed custody agreement with IIROC. The custody agreement includes the terms upon which such securities are deposited and includes provisions that no use or disposition of the securities shall be made without the prior written consent of the Dealer Member and the securities can be delivered to the Dealer Member promptly on demand. IIROC has executed these agreements on behalf of its members in order to reduce the need for the issuer or its agent to enter into individual agreements with each Dealer Member it deals with. As an alternative, an issuer or its agent may sign the prescribed custody agreement directly with the IIROC Dealer Member.

How often is the approved bare trustee list produced?

The approved listing for bare trustee agreements is updated and produced on a monthly basis. It can be found on the IIROC website under “Dealer Member Rules / IIROC Notices”.

What administrative role does IIROC play in approving the bare trustee agreement?

The former IDA (now IIROC) and the Canadian Investor Protection Fund (“CIPF”) entered into an Agreement dated May 9, 2005 in which all existing custody agreements executed in the name of the CIPF as bare trustee have been assigned to IIROC to administer on a go forward basis. In the administration of these custody agreements, IIROC carries out due diligence to ensure that the bare trustee agreement is in prescribed form and is duly executed by those in authority. Copies of the agreement on file are available upon request.

What is the role of the Dealer Member?

It remains the responsibility of the Dealer Member to carry out product due diligence and suitability assessment of investments sold to clients.

What is the role of a Fund Manager?

To fully understand the extent of the activities and role that a fund manager (sometimes referred to as a fund administrator) plays, the following are many of its primary functions:

Calculating the NAV and the NAV per share or unit;

Keeping the accounts and financial records;

Preparing the annual audit file and liaising with the auditor;

Liaising with the fund advisor, the custodian, the brokers and other service providers;

Liaising with prospective investors and sending out the offering documentation;

Calculating, confirming and arranging payment of all subscriptions, redemptions, fees and expenses, and arranging for the payment of all dividends or other distributions, if required;

Maintaining the statutory books and records;

Acting as registrar and transfer agent, handling the registration of shares and liaising with shareholders with regard to subscriptions, redemptions and transfers;

Carrying out anti-money laundering due diligence with regard to investors;

Acting as company secretary, responsible, amongst other things, for arranging board meetings, calling the annual general meeting and preparing board minutes;

Maintaining a copy of the share register at its offices and, if the administration is not resident in the domicile of the fund, ensuring that the original share register is held in the registered office in that jurisdiction; and

Ensuring that the fund complies with the terms of its offering memorandum.

What is the required documentation for including a Fund Manager on the monthly IIROC bare trustee custodial agreement listing?

2 signed copies of the bare trustee agreement (not negotiable in terms of amending the agreement).

Proof that the Fund Manager or Fund Advisor is registered with either a Provincial Securities Commission as an Investment Fund Manager or the Office of the Superintendent of Financial Institutions (“OSFI”).. Any other type of securities registration will be reviewed by IIROC for approval. The fund manager is defined as the entity responsible for the fund administration. See question 5 above.

Copy of the offering memorandum (or prospectus if applicable).

A corporate resolution for signing authority.

Articles of incorporation.

A letter from an IIROC Dealer Member confirming that they will be distributing the investment product.

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To assess financial and compliance risk, IIROC staff weight various kinds of risk alongside the controls that firms use to manage that risk. Click here to view the formula.

How do FinOps staff assess risk? Click here to see a diagram of the assessment structure.